Monday, August 6, 2012

What should we make of this volatile stock market? Just as it seems that the market starts to move in one direction, it reverses course and violently punishes the traders to try to catch the breakouts or breakdowns.

I present my base case scenario below, otherwise known as my wild-eyed guess for the remainder of 2012.

Bear case: Market internals scream "cyclical slowdown"
A review of the relative performance of the US equity sectors scream "cyclical slowdown". Consider this relative performance chart of the Morgan Stanley Cyclical Index (CYC) against the market. Cyclical stocks have been in a relative downtrend since February. The message of the market from relative underperformance of the cyclical sector says "cyclical downturn".

The relative performance of Consumer Discretionary stocks also tell the same story. This sector had been the leaders for quite some time, but this sector is now rolling over on a relative basis, which is not a good sign for the risk-on, high beta trade.

Technology, which I characterize as a growth-cyclical sector, is not providing any leadership either. The relative performance of the equal-weighted NASDAQ 100, which takes out the effects of heavyweight and market darlings such as Apple, has been rolling over on a relative basis.

Similarly, the BoAML Sell-Side Indicator, which measures the average recommended equity exposure of Street strategists, is showing an off-the-charts bearish reading that is contrarian bullish.

A US-only cyclical effect?
How can we reconcile the apparently bearish macro outlook with a bullish sentiment outlook?

If we were to only look at the relative performance of US sectors, the story would look dire. However, an analysis of globally cyclically sensitive indicators don't tell the same story of a cyclical downturn. The chart of Dr. Copper, for example, is showing signs of stabilization. The price of the red metal stopped going down in June and has started to consolidate sideways - indicating that the one big consumer of commodities, i.e. China, may be starting to bottom.

Similarly, the AUDCAD exchange rate has been rallying. Both the Australian and Canadian economies are similar in their commodity exposure. The only difference is Australia is more sensitive to Chinese demand while Canada is more sensitive to American demand. The rally in the AUDCAD rate is an indication that the growth expectations are turning around on the Chinese economy compared American one.

Another indication that the global cycle is not tanking is the relative performance of the cyclically sensitive South Korean market, or economy. The chart below of the relative performance of the Korean ETF against the MSCI All-Country World Index ETF (ACWI) shows Korea to be range bound on a relative basis. The relative performance of Korea against ACWI stands in marked contrast to the relative performance of the CYC against the SPX shown above.

The canary in the German coalmine
So far, we have discussed the US and Asia (mostly China) in considering the market outlook. What about Europe?

My view is that Europe will oscillate back and forth in a volatile fashion, as we go through the cycle of crisis, rescue plan, rescue plan failure, followed by another crisis. Mario Draghi has put together a plan with pre-conditions of what is needed to try to save the eurozone once more (see What did you really expect from the ECB?)

The key to this latest plan remain the Germans. Will the German elite, the Bundesbank and German public acquiesce? My best guess is that they won't blink until German society starts to feel serious pain and fear. Fear will come in the form of a possible collapse of their beloved Landesbank and financial system, which is starting to show strains (see here). The one canary in the German coalmine that I am watching is the share price of Commerzbank, which is one German bank that is known to be close to edge of the precipice. Should CBK collapse, watch for the Germans to blink.

A volatile grind upward for the rest of 2012?
In conclusion, an investor who just focuses on the US market may be inclined to turn bearish. My take is that the leadership will start to shift away from US equities to stocks more exposed to the global cycle. The most likely scenario is that US stocks will follow the election cycle and continue to grind upward, though in a highly choppy fashion.

Key macro risks loom large. That's why the markets will be very volatile and frustrating for investors and traders alike. Take positions, but don't forget to maintain risk controls.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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Welcome to my blog Humble Student of the Markets. These are my observations and musings about the markets (mostly equities), hedge funds and investments in general.My experience has been a quantitative equity manager in US, Canada, EAFE and Emerging Markets and commentator on hedge funds and their returns patterns.

DISCLAIMERThis is not investment advice! I know nothing about you, your risk preferences, your portfolio or your investment horizon. I have no idea whether any of my opinions expressed are suitable for you.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. I may hold or control long or short positions in the securities or instruments mentioned.